Factoring or Collections Agency?

Potential clients often think that because they have a collections agency, they don’t need Factoring. While this might be the case, it is important to note that factoring is a completely different process with different goals, different benefits and should be used for separate purposes.

The only similarity between the two services is that they function to help businesses receive payment on accounts receivables. However they achieve this end through completely different methods.

Factoring works as a cash advance on an accounts receivable. It allows the business to have immediate access to the money that would have otherwise been inaccessible. This means that factoring is a form of financing, leveraging accounts receivables like a revolving line of credit. In a factoring arrangement usually 80% of the value of the receivable will be advanced immediately upon invoicing the customer. Once the factor receives payment on the invoice the remaining 20% is given back to the client minus the factoring fee.

A collections agency, on the other hand, comes into play once the account is delinquent and serves to hasten payment as well as avoid default. If the business has an ‘in-house’ or ‘first party’ collections agency then it will be more geared towards speeding up payment and will get involved earlier in the process compared to a third party collections agency. A ‘third party’ or ‘outside’ collections agency usually deals only with accounts that seem to be a default risk. Third party collections arrangements can work a number of ways. Some agencies make money based on a percentage of the revenue they collect, typically ranging from 25-40% of the value of the receivable. Other agencies work on a flat fee basis, and others will purchase the uncollected debt, usually at a substantial discount, and assume the debt as their own.

It is clear that factoring and collections are two different tools with completely different costs to the business, and affects on cash-flow. Factoring will improve any business’s cash flow, whereas collections can only provide value for businesses that have issues with payment. Even if a business has payment issues, factoring will improve cash flow much more than collections simply because it allows the business to get paid upfront. The cost of factoring compared to collections is completely based on the situational variables; whether the collections where done in-house or through a third-party, what percentage of invoices were being factored, the volume of sales etc. Generally speaking factoring is more expensive then a third party collections agency, and could be significantly less then in-house collections based on the size of the company.

However it is important to note that factoring inherently provides collections services. Factors will keep close watch over the status of an invoice, and if there is an issue or concern with the payment the factor will follow up with the company, and resolve the issue on behalf of their client. This is at no extra cost to the client.

One issue with both factoring and collections agencies is the concern that they will not manage your customer relationship right, and as a result you will lose the customer. This can be a legitimate concern and because of that, there is factoring on a “non notification” basis. What this means is the customer will not know that the invoice was factored and the factor will not contact the customer. Obviously this would negate the aforementioned inherent collection service in a factoring arrangement, as collections cannot be done on a non-notification basis.

It is important for business owners to understand the difference between services so that they can select the service that will best remedy their problem. A collections agency should be used when a business is trying to minimize default. Factoring should not be used for this reason. Factors should be used as a financing tool on quality invoices. Factoring will not provide much value to a business if the factor is assuming invoices that are going to default. Even if factoring is done on a “non-recourse” basis, the factor will usually recoup their money by taking it out of future payments. Therefore selling bad invoices to a factor will only delay the cash flow hit that occurs with non payment. However a collections company can help lessen or eliminate the non payment and would provide more value if default appears to be a significant risk.